SEC Extends Order Limiting Naked Short Selling Through August 12

SEC Extends Order Limiting Naked Short Selling Through August 12
FOR IMMEDIATE RELEASE
2008-155

Washington, D.C., July 29, 2008 â The Securities and Exchange Commission today extended an order issued July 15 to enhance investor protections against naked short selling in the securities of financial institutions to which the Federal Reserve has granted temporary access to liquidity facilities on an emergency basis. The extended order will be in effect until 11:59 p.m. EDT on Aug. 12, 2008, and will not be further extended.

The Commission's decision to extend the order for a second 10-day period, in addition to furthering the purposes of the original order, will permit the Commission staff to collect and analyze additional data on the impact and effect of the order's provisions. Following expiration of the extended order, the Commission will proceed immediately to consideration of rulemaking which would become effective after public notice and comment. The purpose of the rulemaking is to provide additional protections against abusive naked short selling in the broader market, while allowing the legitimate short selling essential to efficient, highly liquid markets.

The SECâs order requires short sellers in the securities of the designated institutions to arrange to borrow the securities at the time of sale so that the buyers will receive the stock they purchased on time. Selling short without borrowing the stock to be sold, and failing to deliver it, is called naked short selling.

âThe order is designed to protect legitimate short selling in these securities, but helps prevent illegitimate naked short selling and potential âdistort and shortâ manipulation,â said SEC Chairman Christopher Cox. âIn addition to continuing the existing order against naked short selling, the Commission will continue exploring other remedies for the broader marketplace to further protect investors from âdistort and shortâ artists.â

Chairman Cox recently reported to the Congress that the Commission will soon consider rulemaking to apply additional protections against abusive naked short selling to the broader market.

The Commissionâs order was issued under its emergency authority provided in Section 12(k)(2) of the Securities Exchange Act of 1934. The Act limits emergency orders to 10 business days. The total duration of the original order plus extensions may not exceed 30 calendar days from the date of the original order.

Short-sellers who have their guns trained on Wall Street firms will have limited ability to fire for another 10 days.

As expected, the Securities and Exchange Commission late Tuesday night extended an emergency order limiting short-selling in 19 big financial stocks for another 10 days. There will be no more extensions: This one will end two days short of the 30-day limit the SEC has for emergency rules.

At issue is naked short-selling, which the agency thinks threatens the stocks of the primary dealers, including all the big Wall Street firms, plus Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE - news - people ). This group of companies has been granted access to the Federal Reserve's emergency lending window, and thus are seen as particularly vulnerable to attack by short sellers as the credit crisis continues.

Shorting a stock involves borrowing it to sell and hoping it will fall so the trader can buy it back at a lower price to cover the loan and profit from the difference. In naked short-selling, the trader never actually borrows the stock. The emergency order demands that traders formally borrow the stock in these 19 protected companies before selling it. Before the order, a trader only needed to get a broker to say the stock was available to borrow.

A stock that's in demand for borrowing to sell short typically costs more to borrow.

A number of companies not protected by the order have lobbied to have it extended to their shares, but to no avail. Washington Mutual (nyse: WM - news - people ), National City Corp. (nyse: NCC - news - people ) and other big banks, not to mention other nonfinancial companies, are still excluded.

The SEC said late Tuesday it was moving swiftly to propose new rules that would extend the pre-borrow requirement to all stocks. "Following expiration of the extended order, the commission will proceed immediately to consideration of rulemaking which would become effective after public notice and comment," the agency said in a statement. "The purpose of the rulemaking is to provide additional protections against abusive naked short selling in the broader market, while allowing the legitimate short-selling essential to efficient, highly liquid markets."

SEC extends restrictions on short selling of Fannie, Freddie, others through Aug. 12

Federal regulators on Tuesday extended through mid-August a temporary order banning a certain kind of short-selling of the stocks of mortgage finance companies Fannie Mae, Freddie Mac and 17 large investment banks.

The Securities and Exchange Commission said the ban on so-called "naked" short selling will be in effect until 11:59 p.m. EDT on Aug. 12 and will not be extended.

Short sellers make a bet that a stock's price will fall so that they can profit from it. They borrow shares of the stock and sell them. If the price drops, they buy cheaper actual shares to cover the borrowed ones, pocketing the difference.

"Naked" short selling occurs when sellers don't even borrow the shares before selling them, and then look to cover positions immediately after the sale. The SEC order requires short sellers to actually borrow shares before selling them.

SEC Chairman Christopher Cox said the order was also helping prevent potential "distort and short" manipulation of stocks, which occurs when rumors and misinformation are used to drive down the price of a stock that has been sold short.

"In addition to continuing the existing order against naked short selling, the commission will continue exploring other remedies for the broader marketplace to further protect investors from 'distort and short' artists," Cox said in a statement.

The SEC said that extending the restrictions on short selling will allow regulators more time to collect and analyze data on the order's impact and effectiveness.

After ban runs out, regulators will move to draw up formal rules to provide additional protections against abusive naked short selling in the broader market, while allowing legitimate short selling, the SEC said.

Advocates for smaller banks and investment firms have been urging the SEC to expand the ban on naked short selling to cover additional financial companies.

Analysts and government regulators blamed aggressive short selling for exacerbating the recent plunge in Fannie Mae and Freddie Mac's stock, as well as that of big investment house Lehman Brothers Holdings Inc.

The SEC initially announced the emergency order on July 15 after a perilous slide in shares of Fannie and Freddie, the government-sponsored companies that together hold or guarantee more than $5 trillion in home mortgages -- nearly half the U.S. total.

The regulators' move followed a 13 percent drop in the price of Fannie shares and a 22 percent plunge in Freddie's on July 10, when a news report said the government had begun contingency planning in the event the companies failed. The next day, Freddie shares plummeted 33 percent at one point and Fannie stock lost 29 percent of its value.

Here's enough information to help you make informed decisions about how to trade. I think retail or prop traders will do very well lin this environment. What it will stop, is HedgeFunds getting a locate on 500,000 shares, selling that stock 5 x over, panicing markets, then covering most of it by the end of the day. That is why the figures you see about 8.5 billion fails, or 20billion fails is misleading. This is all about sleight of hand. This possible solution is tailored to solve what I just described, which proves that the problem does exist.

SEC Naked Short Sale Plans Could Transform Stock Loan Game
By Peter Chapman
July 30, 2008

Last night's announcement by the Securities and Exchange Commission that it would extend the emergency order and consider a permanent ruling targeting naked short selling could lead to dramatic changes in the way the stock loan business is conducted and prove a boon for at least one technology provider.

LocateStock.com is one of a few organizations positioned to cash in on a likely move to more automation in the matching of borrowers and lenders in the stock loan business. Last week, it says it demonstrated its system of matching borrowers with lenders to the SEC, which said it was unaware of any other comparable system.

That's according to John Tabacco, LocateStock.com's president. "We are not part of any solution," Tabacco told Traders Magazine. "We are the solution." The SEC declined to comment.

LocateStock.com licenses its platform to prime brokers who then make it available to their customers, hedge funds looking to borrow and short, and stock lenders such as banks. The Jersey City-based technology shop has licensed the platform to three broker-dealers. About 85 institutions -- borrowers and lenders -- use the platform, accounting for 3,500 individuals.

The firm launched its Matador product on January 5, 2005, the day the SEC's Reg SHO short sale ruling went into effect.

There are other organizations such as iCap and Quadriserve automating what many see as an antiquated stock loan business, but their approaches are slightly different. Quadriserve attempted to match borrowers with lenders in competition with prime brokers, but recently pulled the plug on that effort when it shuttered its broker-dealer subsidiary.

In any event, more automation is likely coming to the industry. As the stock loan business is largely manual today, any pre-borrow requirement could slow down the system. "A pre-borrow requirement does increase the use of automation in the securities lending business," according to Josh Galper, a principal with consultancy Vodia Group and the author of several reports on the securities lending field. "Brokers will need technology to manage the process of decrementation of inventory. This is a cumbersome process to handle manually."

Galper explains that any technology solution to the pre-borrow requirement must do two things: accurately decrement inventory and track those securities through when a short sale is made.

The SEC, last night, extended its order requiring short sellers to "pre-borrow" 17 financial stocks they want to short by having an agreement in hand to borrow the stock. The ruling is meant to prevent a short from going "naked," or shorting without actually locating the stock beforehand.

The regulator also announced that after the emergency order expires on August 12, it would "proceed immediately to consideration of rulemaking which would become effective after public notice and comment." That would "provide additional protections against abusive naked short selling in the broader market," the SEC said.

Any ban would lead to less shorting initially, according to Galper. That's because obtaining a pre-borrow will be more costly, as not all borrowers will be able to line up the stock they want to short.

According to Harvey Pitt, former SEC chairman and current chief executive of consultancy Kalorama Partners, the SEC also wants to see a technological solution to the problem of "abusive short selling."

Pitt said in a statement that "short selling helps create market liquidity, and offsets irrational exhuberance in our securities markets. But "naked short sellers hurt companies and investors." Kalorama Partners recently formed a partnership with LocateStock.com to provide the Lendex stock loan marketplace.

Tabacco believes his firm is well positioned to make the process more efficient. "The regulatory climate will mandate that firms that want real-time, instantaneous, dynamic locates will have to use it," he says. "Because without our solution, people will have to pick up the phone and call their clearing house and wait to get allocated."

...and this, coincidences of coincidences, spells out how it's done, and that no borrow is involved. That 25% year to year is going to be tough to maintain. First article I've ever seen addressing the game.

If the Securities and Exchange Commission expands its clampdown on short-selling, it is widely expected to slam hedge funds like Stephen Cohen's SAC Capital and James Simon's Renaissance Technologies, which profit from fast-and-furious trading, experts predicted.

That's because under the long-accepted rules of the short-selling game, these hedge funds, which often trade through sophisticated computer programs, have been able to skip the process of borrowing the shares needed to cap off their short positions.

But that luxury is now being challenged by the SEC's mandate requiring investors who short 19 financial stocks, including Fannie Mae and Freddie Mac, to borrow the shares they short before they bet against the stock whose price they predict will fall.

Previously, short sellers could rely on a broker's promise that the shares could be delivered, if need be, within a few days.

"The guys who do the rapid trading stuff, they're shorting without having to borrow because they know they're going to close out by the end of the day," said one hedge fund manager. "Those are the people who are going to be most impacted by this."

Under the new rules, "if a prime broker does not have it physically pre-borrowed, those trading opportunities may be gone," said well-known short trader Jim Chanos, speaking on behalf of his organization, which is lobbying against the SEC's rules.

Among those most likely to be affected are day-trading shops like SAC, Renaissance and Ken Griffin's Citadel Investment Group, which trade shares so quickly they rarely need the shares to be delivered.

Late Tuesday, the SEC extended an emergency order limiting short selling in the 19 financial stocks for another 10 days - and it's unclear what it will propose next.

"Previously, short-term traders could avoid having to borrow by closing out their position within a few hours or a day," said Elliott Curson, partner at law firm Dechert.

Hedge-fund officials generally say they dislike the SEC's actions, but some are more distressed than others. Controversial short seller, David Einhorn, in an interview with the Financial Times, called the move "peculiar" but said it hasn't hindered his trading as of yet.

Those who tend to hold their positions for the long-term, like activist investor Oliver Press Partners, also aren't worried. "I think it's kind of silly," said partner Clifford Press. "It's going to be ineffective. If people want to short they still can - through options."

The Bonkers Journalism of Barronâs Magazine
July 31st, 2008 by Mark Mitchell
If it seems odd to you that respected and influential news publications would urge the government to provide get-out-of-jail-free cards to criminal stock manipulatorsâ¦well, welcome to the Deep Capture team. Weâve witnessed a lot of freakish journalism during the past few years, but it never ceases to amaze.

A nice example can be found in the latest Barronâs magazine, where the lead editorial chides the SEC for issuing an emergency order to âstop unlawful manipulationâ that threatens to crash the American financial system.

According to Barronâs, the SEC âwaved a newspaper and swatted the imaginary fly of naked short-selling. It made a big noise, but thereâs no dead bug.â

That word âimaginaryâ has a ring of familiarity. âSeeing shadows on the wall,â is how Bethany McLean of Fortune magazine once described concerns about naked short sellers. âSeeing UFOsâ was the phrase employed by CNBCâs Herb Greenberg, then writing for MarketWatch. But in the face of all the evidence, those journalists have been silent on the issue for months, and now everybody from the Secretary of the Treasury on down says that illegal naked short-selling is an abomination.

Certainly, there is nothing âimaginaryâ about the SEC data showing that as of March 31, $8.7 billion worth of stock had âfailed to deliver.â Most of those failures were the result of illegal naked short selling â hedge funds and their brokers offloading stock that they had not, and never intended, to borrow. Experts agree that there is at least ten times more of this phantom stock in parts of the system â such as âex-clearingâ â for which the SEC provides no public data.

Barronâs is right, thereâs âno dead bugâ â naked shorting is alive and well. But that doesnât mean it shouldnât be swatted. Maybe the SEC just needs a better newspaper â something other than the limpid Barronâs.

But wait. Hereâs a newsflash: Naked short selling is good clean fun â nothing illegal about it. âAggressive short-selling isnât a crime,â Barronâs writes. âEven naked short-selling â selling shares before borrowing them â hasnât been against the rules. Until last week, a short-seller could enter a naked trade in almost any stock if his broker had reasonable grounds to expect that an adequate number of shares could be borrowed by the day of settlement.â

That is technically true, but its is plainly disingenuous for Barronâs to suggest that the SEC is cracking down on legal behavior. The problem, as Barronâs editors surely know (they do cover Wall Street, donât they?), is that short-sellers and their brokers routinely offload stock without having âreasonable groundsâ that they can borrow it. That is why more than $8 billion of stock âfails to deliverâ on a typical âday of settlement.â Moreover, the data shows that most of this phantom stock is targeted at specific companies, and that much of it remains undelivered for months, even years, at a time.

In an earlier issue, Barronâs itself described the case of Cal-Maine Foods, the countryâs largest egg producer, noting that, âOf the 55% of Cal-Maineâs stock thatâs available to the public, more than 100% is sold short. That suggests short sellersâ¦are executing sales before taking the normal step of securing shares to borrow.â

There is no legal gray area where hedge funds are allowed to sell more of a companyâs stock than actually exists. This sort of naked short selling is not some technical glitch. It is illegal market manipulation. It is clear-cut fraud. And it is happening on a massive scale.

That is why the SEC seems to want to crack down. Its emergency order protects only 19 big financial firms, but hopes are high that the Commission will extend its protection to the many companies, such as Cal-Maine, that are far more seriously affected. The hedge fund lobby and Barronâs will whine loudly, but it seems like common sense that short-sellers market-wide should be required to pre-borrow (i.e. have real stock) before they dump it on unsuspecting investors.

Really, I challenge Barronâs, or anybody else, to name just one expert (people working for hedge funds donât count) who has published a study casting doubt on the thesis that naked short selling is routinely used to illegally manipulate markets â with potentially catastrophic consequences. I have yet to come across any such expert, and there is no evidence that Barronâs has either. Indeed itâs editorial contains no facts or data â just platitudes.

Itâs only real-world example is the much-discussed demise of Bear Stearns. Short-sellers, we are told, had nothing to do with the bankâs collapse. All the rumors were true. The only falsehoods were told by Bear Stearns spokesmen, âwho declared that everything was hunky-dory.â Thatâs how it happened â take Barronâs word for it.

Ugh. This âdebateâ is like arguing over how many Froot Loops are in the box. Itâs absurd â letâs just take them out and count. We did that, and the number we got was 1.2 million. Thatâs the number of Bear Stearns shares that were sold on March 12, but remained undelivered after the 3 days allotted for settlement. The shares were undelivered because they were as fake as the Froot in your Loops.

And note that the increase in phantom shares on March 12 was at least ten times the increase in the total volume of trading in Bear Stearns stock, suggesting that selling of real shares was comparatively light. In other words, there was no panic among investors until after those 1.2 million phantom shares (and probably a lot more in ex-clearing) flooded the marketplace, creating the illusion that somebody was panicking. .

That afternoon, CNBC, working from information provided by a hedge fund, reported (as if it were fact) the bombshell that Goldman Sachs had cut off Bearâs credit. This was the first time the media had reported anything so drastic about the bank. And the report was completely false. Message to Barronâs editors: the rumors were not true. May I humbly suggest that you investigate this.

The truth is that on the morning of March 12, Bear Stearns was an unhealthy company, but it had $17 billion in cash, and few people believed that it was on the brink of collapse. Nobody had cut off its credit. No major clients had pulled out their money.

The next day, everybody pulled out their money. Bear Stearns was gone. What was the trigger? Iâm open to other suggestions (Barronâs provides none), but it seems quite obvious there is only one explanation: A whole lot of phantom stock (the illusion of panicked selling) on March 12, combined with a well-timed media atrocity that afternoon, precipitated a real panic the following day.

We can assume that the SEC agrees with this version of events. That is why it believed that rumor-mongering naked short sellers had the potential to destroy 19 big financial firms. Maybe those 19 institutions are all bad companies. Maybe they should all be out of business. If so, let them fail naturally and gradually. Donât allow law-breaking hedge funds to manufacture mass hysterias that could crash the financial system.

Itâs hard to say why Barronâs doesnât grasp this, but perhaps it is significant that it felt compelled to include in its editorial a little disclaimer about the magazineâs relationships with short-sellers. The editorial notes with apparent pleasure that Barronâs is âsometimes known on the Street as âBear-onsââ¦.[and] it prides itself on offering accurate negative news about companies as much as it does about passing on accurate good news. Good news is plentiful, and therefore cheap. Bad news has to be dug upâ¦.Short-sellers read Barronâs with special interest, and they also make good sources of information that our reporters can check and publish if true.â

Iâd be hard pressed to provide a better description of what plagues certain segments of our financial media. Start with the appalling notion that âgood newsâ is âcheap.â The way I see it, all news is equally valuable â so long as itâs true and interesting. Itâs a bit rich to suggest that good news is more âplentifulâ when short-sellers have become such âgood sources of information.â In any case, interesting, nuanced truths usually contain some good news, some bad. And they tend to be discovered by independent thinkers who do their own research, not by some ping-pong headed note-taker who bounces between the conniving short and the corporate VP of Puff until deadline comes and confusion reigns, but one thing is certain â the editor has decreed that good news is âcheap.â

Even worse than the bias for bad news is Bear-onâs implicit assumption that because short-sellers are âgood sources of information,â the government (and the media?) should leave them alone, even if theyâre committing crimes. There is nothing wrong with journalists talking to short-sellers. But while theyâre at it, they might ask some short-sellers why their target companies are buried under heaping piles of phantom stock.

Barronâs has worked closely with some pretty dastardly shorts while obligingly keeping its nose out of their shady business dealings. Short-seller David Rocker, for example, was a popular source and Barronâs columnist while he was conspiring with a disreputable outfit called Gradient Analytics. Gradient advertised itself as providing âindependentâ research, but former employees say its falsehood-laden hatchet jobs were often dictated by Rocker, who illegally traded ahead of them, while one of Gradientâs managers was accumulating phony social security numbers and fake IDs to hide his activities.

Most of Rockerâs short targets appeared on the SECâs list of companies victimized by excessive levels of phantom stock â purely coincidence, no doubt, but Barronâs might have asked him about it.

For a long time, Barronâs editor Cheryl Straus Einhorn published a steady stream of biased stories that generated financial rewards for associates of her husband, a hedge fund manager and master of distortion named David Einhorn. Meanwhile, Barronâs couldnât get enough of the âgood informationâ provided by short-seller Anthony Elgindy, a gun-toting, Mafia-connected goon who was well-known for selling phantom stock, bribing FBI officials, extortion, blackmail â you name it.

Barronâs has since fired Ms. Einhorn, Elgindy is now doing 11 years in a federal penitentiary, and Rocker slunk into retirement in Florida (and got a âhomestead exemptionâ protecting his assets from seizure) after the government issued him with a subpoena.

Fortunately, Barronâs still has some âgood sources of informationâ and no doubt they are all model citizens. But the latest editorial shows that the magazine is as reluctant as ever to publish the bad news about short-sellersâ crimes.

Funny that â with good news being so âcheapâ and all.

Mark Mitchell is the former editor of the Columbia Journalism Reviewâs on-line review of business journalism. He has also worked as an editorial writer for the Wall Street Journal in Europe, and as a correspondent for Time magazine in Asia, and the Far Eastern Economic Review.